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PROJECT REPORT ON FUTURE, OPTION & SWAPS

SUBMITTED TO :- SUBMITTED BY :-

ANOOP RAJ SIDDHARTH SHANKARRAI

FT(FS)-11-379

MO. 09718087800


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DERIVATIVE

A derivative is a product whose value is derived from the value of one or more underlying

variables or assets in a contractual manner. The underlying asset can be equity, forex,

Commodity or any other assets. In our earlier discussion, we saw that wheat farmers may

wish to sell their harvest at a future date to eliminate the risk of change in price by that date.

Such a transaction is an example of a derivative. The price of this derivative is driven by the

spot price of wheat is the underlying in this case.

The forwards contracts (regulation) Acts, 1952, regulates the forward/futures contracts in

commodities all over India. As per this the forward Markets commission (FMC) continues to

have jurisdiction over commodity futures contracts. However when derivatives trading in

securities was introduced in 2001, the term security in the securities contracts (Regulation)Act, 1956 (SCRA), was amended to include derivative contracts in securities. Consequently,

regulation of derivatives came under the purview of Securities Exchange Board of India

(SEBI). We thus have separated regulatory authorities for securities and commodities

derivative markets.

Derivatives are securities under the SCRA and hence the trading of derivative is governed by

the regulatory framework under the SCRA. The securities contracts (Regulation) Act, 1956

defines derivative to include- A security derived from a debt instrument, share, loan

whether secured or unsecured, risk instrument or contract differences or any form of security.

A contract which derives its value from the price, or index of prices, of underlying securities.

TYPE OF DERIVATIVE

Derivative

Future

OPTION

Swaps

Forward


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FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy

or sell a certain underlying instrument at a certain date in the future, at a certain date in the

future, at a pre-set price is price is called the futures price. The price of the underlying asset

on the delivery date is called the settlement price. The settlement price, normally, converges

towards the future price on the delivery date.

A futures contract gives the holder the right and the obligation to buy or sell, which differs

from an options contract, which gives the buyer the right, but not the obligation, and the

option writer (seller) the obligation, but not the right. To exit the commitment, the holder of a

futures position has to sell his long position or buy back his short position, effectively closing

out the futures position and its contract obligations. Futures contracts are exchange traded

derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization:Futures contracts ensure their liquidity by being highly standardized, usually by specifying:

The underlying: This can be anything from a barrel of sweet crude oil to a short terminterest rate.

The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying assets per contract. This can be the notional

amount of bonds, a fixed number of barrels of oil, units of foreign currency, the

national amount of the deposit over which the short term interest rate is traded, etc.

The currency in which the futures contract is quoted. The grade of the deliverable. In case of bond, this specifies which bonds can be

delivered. In case of physical commodities, this specifies not only the quality of the

underlying goods but also the manner and location of delivery. The delivery month.

The last trading date. Other details such as the tick, the minimum permissible price fluctuation.

2. Margin:Although the value of a contract at time of trading should be zero, its price constantly

fluctuates. This renders the owners liable to adverse changes in value, and creates a creditrisk to the exchange, who always acts as counterparty. To minimize this risk, the exchange


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demands thats contract owners post a form of collateral, commonly known as margin

requirements are waived or reduces in some cases traders who have physical ownership of the

covered commodity or spread traders who have offsetting contracts balancing the position.

Initial Margin: is paid by buyer and seller. It represents the loss on that contract, as

determined by historical price change which is not likely to be exceeded on a usual days

trading. It may be 5% or 10% of total contract price.

Mark to markets Margin: because a series of adverse price changes may exhaust the initial

margin, a further margin, usually called variation or maintenance margin, is required by the

exchange. This is calculated by the futures contract, i.e agreeing on a price at the end of each

day, called the settlement or mark-to-market price of the contract.

To understand the original practices that a future traders, when taking a position, deposits

money with the exchange, called a margin . This is intended to protect the exchange

against loss. At the end of every trading day, the contract is marked to its present market

value. If the trader is on the winning side of a deal, his contract has increase in value that day,

and the exchange pays this profit into account. On the other hand, if he is on the losing side,

the exchange will debit his account. If he cannot pay, then the margin is used as the collateral

from which the loss is paid.

3. Settlement:Settlement is the act of consummating the contract, and can be done in one of two ways, as

specified per type of future contract.

Physical delivery the amount specified of the underlying asset of the contract isdelivered by the seller of the contract to the exchange, and by the exchange to the

buyers of the contract. In practices, it occurs only on a minority of contracts. Most are

cancelled out by purchasing a covering position- that is, buying a contract to cancel

out an earlier sale (covering a short), or selling a contract to liquidate an earlier

purchase (covering a long).

Cash settlement a cash payment is made based on the underlying reference rate,such as a short term interest rate index such as Euribor, or the closing value of a stock

market index. A futures contract might also opt to settle against an index based on

trade in a relation spot market.

Expiry is the time when the final prices of the future are determined. For many equity

index and interest rate futures contracts, this happens on the last Thursday of certain

trading month .on this day the t+2 futures contract becomes the t forward contract.


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PRICING OF FUTURE CONTRACT

in a future contract, for no arbitrage to be possible, the price paid on delivery (the forward

price) must be the same as the cost (including interest) of buying and storing the asset. In

other words, the rational forward price represents the expected future value of the

underlying discounted at the risk free rate. Thus, for a simple, non dividend paying assets,

the value of the future/forward, F(t), will be found by discounting the present value S(t) at

t to maturity T by the rate of risk- free return r.

F(t) = S(t) * (1+r)(T-t)

This relationship may be modified for storage cost, dividends, dividend yield, and

convenience yields. Any deviation from this equality allow for arbitrage as follows.

In the case where the forward price is higher:

1. The arbitrageur sells the futures contract and buys the underlying today (on the spotmarket) with borrowed money.

2. On the delivery date, the arbitrageur hands over the underlying, and receives theagreed forward price.

3. He then repays the lender the borrowed amount plus interest.4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower:

1. The arbitrageur buys the futures contract and sells the underlying today (on the spotmarket); he invests the proceeds.

2. On the delivery date, he cashes in the matured investment, which has appreciated atthe risk free rate.

3. He then receives the underlying and pays the agreed forward price using the maturedinvestment.[if he was short the underlying, he returns it now.]

4. The difference between the two amounts is the arbitrage profit.DISTINCTION BETWEEN FUTURES AND FORWARDS CONTRACTS

FEATURE FORWARD CONTRACT FUTURE CONTRACT

Operational Mechanism Traded directly between two

parties (not traded on the

exchanges.)

Traded on the exchanges.

Contract Specifications Differ from trade to trade. Contracts are standardized

contracts,

Counter- party risk Exists. Exists. However, assumed by


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the clearing corp. which

becomes the counter party to

all the trades or

unconditionally guarantees

their settlement.

Liquidation Profile Low, as contracts are tailor

made contracts catering to

the needs of the needs of the

parties.

High, as contracts are

standardized exchange traded

contracts.

Price Discovery Not efficient, as markets are

scattered.

Efficient, as markets are

centralized and all buyers

and sellers come to a

common platform to discover

the price.

Examples Currency markets in India. Commodities, future, index

futures and individual stock

futures in India.

OPTION

Options are basically the financial instruments that give the buyers the right to buy or sell

the underlying security within a point of time in the future for a price, which is fixed at the

time when the option is bought. The stock option buyers are called the holders and sellers are

called writers in option trading terminology.The call in option trading gives the owner of option a right but not an obligation to buy an

underlying security within the specified time while the put gives the owner a right but not

the obligation to sell the underlying assets within the specified time at a pre-fixed price. The

value of a stock option contract is determined by five factors the strike price, price of the

stock, the expiration date, the cumulative cost that is required to hold a position in the stock

and the estimated future volatility of the stock price. The strike price is referred to the price

for which an option stock can be bought or sold. For calls, the stock price must go above the

strike price while for puts the stock price should be below the strike price.

AT PREMIUM

When you buy an option, the purchase price is called the premium. If you sell, the premium is

the amount you receive. The premium is not fixed and charges constantly- so the premium

you pay today is likely to be higher or lower than the premium yesterday or tomorrow. What

those changing price reflect is the give and take between what buyers are willing to pay and

what seller are willing to accept for the option. The point at which theres agreement becomes

the price for that transaction, and then the process begins again.


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If you buy option, you start out with whats known as a net debit. The means you have spent

money you might never recover if you dont sell your option at a profit or exercise it. And if

you do make money on a transaction, you must subtract the cost of the premium from any

income you realize to find net profit.

As seller, on the other hand, you begin with a net credit because you collect the premium. If

the option is never exercised, you keep the money. If the option is exercised, you still get to

keep the premium, but are obligation to buy or sell the underlying stock if youre assigned.

THE VALUE OF OPTIONS

A particular options contract is worth to a buyer r seller is measured by how likely it is to

meet their expectations. In the language of options, thats determined by whether or not the

option is, or is likely to be, in-the-money or out- the- money at expiration. A call option is inthe-money if the currency market value of the underlying stock is above the exercise price

of the option, and out-of-the if the currency market value of the underlying stock is below the

exercise price and out-of-the-money if it is above it if an option is not in-the-money at

expiration, the option is assumed to be worthless.

An options premium has two parts an intrinsic value and a time value is and what the

premium is. The longer the amount of time for market condition to work to your benefit, the

greater the time value.

OPTION PRICES

Several factors, including supply and demand in the market where the option is traded, affect

the price of an option, as is the case with an individual stock. Whats happening in the overall

investment markets and economy at large are two of the broad influences. The identity of the

underlying investment, how it traditionally behaves, and what it is doing at the moment are

more specific ones. Its volatility is also an important factor, as investors attempt to gauge

how likely it is that an option will move in-the-money.

1. CALL OPTION:An agreement that gives an investor the right (but not the obligation) to buy a stock,

bond, commodity, or other instrument at a specified price within a specific time

period.

Example:

Mr. X Purchases the 3000 Nifty Feb 09 Call Option at Rs.100.

If Price goes up. The value of call option will go up

If Price goes down. The value of call option will go down


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If Price remains constant the value of call option will come down.2. PUT OPTION:

An agreement that gives an investor the right (but not the obligation) to Sell a stock,bond, commodity, or other instrument at a specified price within a specific time

period.

Example:

Mr. X Purchases the 3000 Nifty Feb 09 Put Option at Rs.100. If Price goes down. The value of Put option will go up If Price goes up. The value of Put option will go down If Price remains constant the value of Put option will come down.

LEVERAGE & RISK

There is an important implicit assumption in that account, however, which is that the

underlying levered asset is the same as the unlevered one. If a company borrows money to

modernize, or add to its product line, or expand internationally, the additional diversification

might more than offset the additional risk from leverage. Or if an investor uses a fraction of

his or her portfolio to margin stock index futures and puts the rest in a money market fund, he

or she might have the same volatility and expected return as an investor in an unlevered

equity index fund, with a limited downside. So while adding leverage to a given asset always

adds risk, it is not the case that a levered company or investment is always riskier than an

unlevered one. In fact, many highly-levered hedge funds have less return volatility than

unlevered bond funds, and public utilities with lots of debt are usually less risky stocks than

unlevered technology companies.

IN THE MONEY, AT THEMONEY & OUT OF THE MONEYWhen the price of the underlying security is equal to the strike price, an option is at-the-money.

A call option is in-the-money if the strike price is less than the market price of the underlying

security. A put option is in-the-money if the strike price is greater than the market price of the

underlying security.

A call option is out-of-the-money if the strike price is greater than the market price of the

underlying security. A put option is out-of-the money if the strike price is less than the

market price of the underlying security


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TIME DECAY

Time decay of an option begins to accelerate in the last 60 to 30 days before expiry, provided

the option is not in the money. But in the case of options that are deep in the money, time

value decays more rapidly. The market finds these options too expensive compared to other

strike prices or futures. As such, the holders of deep-in-the-money options nearing expiry

discount the time value to attract buyers and in turn realize the intrinsic value.

EXPIRATION DAY

The last day that an options or futures contract is valid. When an investor buys an option, the

contract gives them the right but not the obligation to buy or sell an asset at a predeterminedprice, called a strike price, within a given time period, which is on or before the expiration

date. If the investor chooses not to exercise that right, the option expires and becomes

worthless and the investor loses the money paid to buy the option.

TYPE OF OPTION

As per Maturity1. Current Month Option2. Next Month Option3. Far Month Option As per Right to Exercise1. European Option2. American Option

OPTION STRATEGIES:

(a)Bullish Strategies Buy Lower Strike Call Option & Sell Higher Strike Call Option. Buy Lower Strike Put Option & Sell Higher Strike Put Option. Buy one Future and One ATM Put and Sell one OTM Call.(b)Bearish Strategies


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Buy Higher Strike Call Option & Sell Lower Strike Call Option. Buy Higher Strike Put Option & Sell Lower Strike Put Option.(c)Long Straddle Buy same strike price call and put option. It is beneficial when market looks very volatile. Trader has to pay time value.(d)Short Straddle Sell same strike price call and put option. It is beneficial when market looks range bound. Trader will receive time value.(e)Long Strangle Buy Different strike price call and put option. It is beneficial when market looks very volatile. Trader has to pay time value.(f) Short Strangle Sell different strike price call and put option. Short Strangle It is beneficial when market looks range bound Trader will receive time value.

SWAPS

In finance, a swap is a derivative in which counterparties exchange cash flows of one

party's financial instrument for those of the other party's financial instrument. The benefits in

question depend on the type of financial instruments involved. For example, in the case of a

swap involving two bonds, the benefits in question can be the periodic interest (or coupon)payments associated with the bonds. Specifically, the two counterparties agree to exchange

one stream of cash flows against another stream. These streams are called the legs of the

swap. The swap agreement defines the dates when the cash flows are to be paid and the way

they are calculated. Usually at the time when the contract is initiated at least one of these

series of cash flows is determined by a random or uncertain variable such as an interest

rate, foreign exchange rate, equity price or commodity price.

The cash flows are calculated over a notional principal amount. Contrary to a future,

a forward or an option, the notional amount is usually not exchanged between counterparties.

Consequently, swaps can be in cash or collateral.


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TYPR OF SWAPS

The five generic types of swaps, in order of their quantitative importance, are: interest rate

swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are alsomany other types of swaps.

INTEREST RATE SWAPS:

The most common type of swap is a plain Vanilla interest rate swap. It is the exchange of a

fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15

years. The reason for this exchange is to take benefit from comparative advantage. Some

companies may have comparative advantage in fixed rate markets, while other companies

have a comparative advantage in floating rate markets. When companies want to borrow,

they look for cheap borrowing, i.e. from the market where they have comparative advantage.

However, this may lead to a company borrowing fixed when it wants floating or borrowing

floating when it wants fixed. This is where a swap comes in. A swap has the effect of

transforming a fixed rate loan into a floating rate loan or vice versa. For example, party B

makes periodic interest payments to party A based on a variable interest rate

of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a

fixed rate of 8.65%. The payments are calculated over the notional amount. The first rate iscalled variable because it is reset at the beginning of each interest calculation period to the

then current reference rate, such as LIBOR. In reality, the actual rate received by A and B is

slightly lower due to a bank taking a spread.

CURRENCY SWAPS

A currency swap involves exchanging principal and fixed rate interest payments on a loan in

one currency for principal and fixed rate interest payments on an equal loan in anothercurrency. Just like interest rate swaps, the currency swaps are also motivated by comparative

advantage. Currency swaps entail swapping both principal and interest between the parties,

with the cashflows in one direction being in a different currency than those in the opposite

direction. It is also a very crucial uniform pattern in individuals and customers.

COMMODITY SWAPS

A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged

for a fixed price over a specified period. The vast majority of commodity swapsinvolve crude oil.


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CREDIT DEFAULT SWAPS

A credit default swap (CDS) is a contract in which the buyer of the CDS makes a series of

payments to the seller and, in exchange, receives a payoff if an instrument - typically a bond

or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the

payoff can be a company undergoing restructuring, bankruptcy or even just having its credit

rating downgraded. CDS contracts have been compared with insurance, because

the buyer pays a premium and, in return, receives a sum of money if one of the events

specified in the contract occur. Unlike an actual insurance contract the buyer is allowed to

profit from the contract and may also cover an asset to which the buyer has no direct

exposure.

FINANCIAL SWAPS

Financial swaps constitutes a funding technique which permit a borrowers to access one

market and then exchange the liability for another type of liability. It also allows the investors

to exchange one type of assets for another type of asset with a preferred income stream.

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